How to Avoid A Repeat of the Housing Market Mess

HR 3915 is not the answer. We've been here before (in the early 1990s), congress did something remarkably similar except a little bit more sane. It didn't work then. Why would we expect it to work this time? Among many other problems with the bill, if prohibiting yield spread being used by brokers to pay loan costs and their own compensation is a good thing, why not get the whole of the problem and prohibit lenders from selling notes above face value at all? The differences are two: The premium that lenders make from selling loans above face value is more than yield spread (usually double yield spread or more) and whereas yield spread is disclosed to consumers, the premium a loan will sell for on the secondary market is not. This proposal is a payoff to lending industry campaign supporters, in order to make it more difficult for brokers to compete. Nor is there any legal requirement for a lender to offer yield spread. If lenders feel it is being abused, they have the ability to refuse to offer yield spread. But of course, then the lenders that continue to offer it will attract more business from brokers - an incentive for individual lenders to make more money by breaking ranks with their competitors. Lest you not understand, if individual lenders can not break legally do this, the lenders as a whole will make more money, and consumers will lose.

I've also seen proposals put forth that federal licensing, a la the NASD, will solve the problem. Preposterous. There's lots of counter-evidence on this one. Black Monday 1987. The dot com bubble of 1996-2000. Pretty much everybody in the securities business is multiply licensed, and it didn't prevent either one of these. The securities business may be a little tighter than the real estate business, but that doesn't make it something to emulate, nor does it mean that licensing will solve problems, as I have illustrated with these two well-known examples, and could illustrate with many others, less well-known but no less telling. If we're going to have licensing requirements, I favor toughening those requirements, but not for this reason.

The causes of this mess are not simple, and a real solution will not fit in a sound bite.

The problem was one of responsibility. Responsibility in law and legal responsibility in fact.

Lending practices had become decoupled from responsibility. Not only had the lenders become insulated from the consequences of offering ill-considered loan programs, mortgage originators had become insulated from the consequences of making an unsustainable loan, the agent from the consequences of selling clients a more expensive property than they can afford.

The point of immediate failure was the loans associated with real estate, and so I'm going to focus there for this article. It wasn't buyer cash, or the price of housing. You can do anything you want with your cash, and the worst thing that can happen is that you don't have it for something else. If the day after you buy a million dollar property for cash, the market collapses and it's suddenly only worth fifty cents, you've still got that property, you just don't have the million dollars for other uses. Whatever the purpose it was going to be used for, it can still be used for. There are no issues with being unable to make monthly payments, no need to refinance when you're upside down because you can't make those payments, and you're not on the hook for money you probably don't have and can't get by selling the property. That's part of money management for adults. But for loans, you're making payments on existing debt with money you are theoretically going to earn in the future. The most critical factor is not the immediate payment. It's the cost of that money - the interest on the loan and the initial costs to procure that loan. Some people still don't understand that these are not the same thing. People tried to pretend that the real cost of the money didn't matter, only the monthly cash flow - until the real cost of the money rose up and bit millions of people in denial. It was the money for debt service that gave people difficulty, and the inability to pay the real cost of that money that financially crippled the vast majority of those that got hurt, and those who are going to get hurt in the coming months.

If I had to look at one place to stop future problems like this before they start, it would be in the loan. How many people would be in difficulty today if lenders had been unwilling to make the loan? That real estate agent can preach for months about how great this house is, Mr. and Ms. Wannabe Homeowner can pine for it all they want, and Mr. and Ms. Seller can proselytize about how wonderful an investment the property is. The fact remains that if the buyers cannot qualify for a loan large enough to buy the property (in combination with their cash on hand), it's not going to happen for those buyers at that price. If they've got the price in cash, there isn't a problem. As I said, the worst that can happen is that they don't have that cash for something else.

The entire lending process was so skewed that it's difficult to communicate to someone who's not a professional in the field. Let me start by describing three of the leading poster children loans that led to the housing meltdown.

100% loan to value ratio loans done on a stated income basis. Stated income loans were an early enabler of the housing boom, and they do have legitimate uses. Their traditional niche is persons who are self employed business persons, who are allowed any number of tax deductions not allowed to the corporate employee, because congress wants to encourage the next Microsoft, the next Google, or the creation of legal, medical, and accounting firms, among others, to foster the competitive element in those professions. If there really were only four accounting firms, they could get together, section the country off, and charge anything they wanted for any quality of service they wanted to deliver - not exactly conducive to happy consumers of these services - and congress gives the owners of those businesses certain tax advantages to encourage the formation of these firms. However, since income is documented via federal tax return, this causes them to be unable to document the same income that someone working as an employee of a larger firm who really is making the same money. Hence, the stated income loan, where someone "states" their income, and in return for a higher interest rate, the bank agrees not to demand documentation of that income. The problem is that if the consumer really doesn't make that income, they're still going to have to pay that same cost of money.

The traditional control upon the stated income loan was nobody did them for 100% of purchase price. And today, we're back to that traditional state of affairs. When you have to put between ten and twenty-five percent of the gross purchase price into the transaction in the form of your hard-earned cash, not only is the lender insulated from losing money if you default, but most people are going to do some hard investigation to make certain they really can afford it and aren't putting that money at risk. Before I write a check for $100,000, I'm going to make darned certain that what comes after is going to enable me to protect that investment. Nor was stated income ever a blank check: You had to be working in a field, and with a job title, where people really do make the income you "stated". Even though the bank wasn't verifying it, it had to be believable. But for several years, these were available for people with credit scores as low as 600 who didn't put anything down. To many people's minds, these consumers weren't really risking anything. here's my rebuttal to one such alleged professional who wrote me an email asking for an endorsement of his program about a year ago. To this way of thinking, this loan removed risk from the prospect of the reward. After all, the consumer wasn't putting any of their hard earned money into the deal, so if it should just not work out for any reason, the consumer could just walk away, whereas if it did, the consumer was in the money! The thinking of these people (who were looking to get paid for their alleged wisdom) was that the consumers weren't risking anything with these loans, so there was no reason not to do these loans and these transactions. As I said then, investment risk is not and never can be zero. There is no such thing as a risk-free investment. Risk can be camouflaged or hidden, but it's still there. Good investment consists of managing that risk. Furthermore, these alleged professionals sold people property and the associated loans based upon this false assessment. Whether a given individual was truly unaware of these consequences, or maliciously lying in order to get a commission, the result should be the same: I put it to you that they are unfit to practice either real estate or loan origination, and they should be permanently barred from the entire real estate industry, after making restitution and serving some appropriate period as involuntary guests of the government.

The 2/28 interest only loan is one of the more common examples of what I have been calling short term adjustable loans. Unlike the 100% stated income loan, which was offered by many A paper lenders for a while, this loan is explicitly subprime. The way this loan, and others of similar mien such as the 3/27 interest only loan, work, is thus: There is an introductory period, during which the loan rate is contractually fixed at a set rate, and the borrower pays only the interest that accrues every month on the loan. For example, if the loan is at 6% for $200,000, the monthly payment is $1000. The attraction is that the payment, and hence, the perceived cost of money, is lower than the same loan fully amortized, for which the payment is $1199. But now let's get to the reason why it was the subprime loan that was offered, instead of the A paper equivalent, various hybrid ARMs such as the 5/1 ARM or 10/1 ARM: Because qualification standards in the subprime world were written to allow borrowers to qualify on the basis of Debt to Income Ratiofor the loan payments at this initial level of payment, rather than based upon the fully indexed payment after this initial period and with a lower maximum debt to income ratio to allow for the fact that that underlying index might well rise, as A paper standards require. Furthermore, thirty year fixed rate loans are available subprime, albeit at higher rates. The net effect of all this was to allow people to qualify for a larger loan than they could really afford, and made sellers, real estate agents, and lenders very happy, and buyers happy for a certain period of time. After all, here they have this house that they didn't think they could afford, much nicer than the one they thought they could afford. It must have been a great bargain, because the apparent cost, or in terms they understood, the payment, was the same!

Unfortunately, that temporary payment is not the real cost of that money. Well, actually it is to begin with in this case, but if that cost changes, and in this instance we know it will, then good risk management means we need to plan for it. In this case, we know from the start that on day 731, that interest rate is jumping to 8.2%, the underlying index plus a margin stated in the contract, and assuming that the index stayed the same, that's what we'd be going to in two years. Bad enough in the case of an amortized 2/28, where we know the payment is going to jump to $1437, a roughly 20% increase over $1199. It's tolerable to do these loans on a refinance for people whose credit just needs a couple years breathing space, after which they'll be eligible for A paper (provided, of course, they know that's what's going on before they sign the application). But for the interest only variant, the payments jump from $1000 per month to $1521, a 52% increase, and that's assuming the underlying index (in this case, the 6 month LIBOR) stays exactly where it was back then.

The most egregious loan of all, the negative amortization loan, should never be a purchase money loan for a primary residence. If you need a negative amortization loan to qualify, you shouldn't buy that property. Period. But it was marketed under all sorts of friendly sounding alternative names, like "Option ARM", "Pick a Pay", and the ever popular "1% loan." Who wouldn't want a loan with a cost of interest of 1%? Sign me up for that!

However, the 1% was a nominal rate only. You were allowed to make payments "as if" your actual loan rate was 1% or something similar. That was not your actual cost of interest for one single solitary second. The actual cost of interest was somewhere between seven and about nine percent, depending upon the situation. This while I had thirty year fixed rate loans in the low 6% range, and lenders were going out advertising to convince people who had gotten 5% thirty year fixed rate loans to refinance into these. You're only writing a check based upon a 1% rate, but they're charging you 8%. That payment is $643 on $200,000, but they're actually charging you $1333 to start with. The difference ($690 the first month!) goes into your loan balance, where they can charge more interest on it next month! Then, when you hit recast (within 5 years at the very most), which in this case we will pick to be 15%, which happens in month 39, and your monthly payment jumps from that $643 to $1756, a 170% increase, and you discover that you now owe $230,000, and the property was only worth $212,000 when you bought it, and you discover it's worth less than that now. You have severe difficulty refinancing to something affordable, even if you didn't trigger a pre-payment penalty. Once again, the lender made the qualification decision based upon the debt to income situation computed using the minimum initial payment! And until the customer is completely unable to pay, the lender is booking all that income from deferred interest. That's what their financial statements write up as income! That bank executive looks like a genius for getting you to sign up for a loan with an interest rate 2% higher than you could have had, or 3% higher than the one you did have. I read an interview conducted with one of those executives back towards the beginning of 2007, who basically said, "The people who sign up for these are all idiots, but I've made a lot of money off them," to which I thought, "No you haven't. The accounting just looks that way right now on paper." Twelve months further on, that company is in bad trouble. To make matters even worse, both this loan and the 2/28 were also offered on a stated income basis!

Lest this be in any way unclear, nobody was coercing lenders into offering these products. They were completely free not to. In fact, I can name a couple of household names that hung back, and never did offer negative amortization loans. But with the huge although false incomes lenders and mortgage investors were reporting upon these three types of loan (and others), there was a mad stampede for a while to see who would offer the most over the top loan program. For that matter, mortgage brokers were free not to participate, and real estate agents were free to limit themselves to real loans their client could afford, and more than one did, not matter how they suffered professionally while their competition was offering make-believe pie-in-the-sky math. But so long as that mortgage broker and their client was following the rules set down by the lender, the only people the lenders can blame is themselves. So long as the mortgage broker and real estate agent made certain their client could in fact afford that loan, there is absolutely nothing wrong with having your client buy a property with a stated income loan for 100% of value. If the program the lender offers falls apart in the aggregate on loans that were precisely as presented, there is no one to blame but the lender themselves.

The problem is that disclosure and transparency were nowhere to be found in the vast majority of these loans. I can imagine otherwise sane adults signing off on all this sort of problem loan even if they were fully informed, but not in the numbers that are causing all of the problems. There are rational reasons why someone might do every single one of those loans. These loan programs are not new - it was the way they were marketed and sold that led people to sign up without understanding the consequences. Lest anyone be unaware, bad consequences hitting large numbers of borrowers always translates to bad consequences for lenders holding those notes, something that the lenders themselves had forgotten.

Lack of real disclosure is at the heart of the problems with our entire system of real estate in general, and of loans in particular. Lack of disclosure of what is going to happen should the consumer stay in that loan. Lack of disclosure as to what is really going on. Lack of disclosure - really a lack of transparency - in the entire loan process. I know - every good loan officer knows - what loans are available and what loans are potentially deliverable to a given applicant. It really doesn't take much in most cases. Credit report, income documentation, purchase contract. Every once in a while there's something unusual going on that prevents the loan you thought you could do, but for the vast majority of loans out there, that's enough to tell a competent loan officer what you qualify for. Furthermore, if a loan officer doesn't know all the salient points of the mortgage loan they're trying to persuade someone to sign up for, I don't think anybody sane would argue that wasn't gross negligence. "I can't tell you what this loan is going to do, but I think it's a really great loan for you!"

In the overwhelming majority of cases, however, that loan officer knew exactly what loan they would be able to deliver, at exactly what real cost, before the borrower signed the loan application to begin the process. They knew exactly what the terms would be, and exactly what the cost would be, exactly what the final loan amount would be, and exactly what the payment would be, not only now, but for the rest of the loan. This is all easy math, and the only thing more difficult than what a third grader needs to know to get into fourth grade is computing the payment once you have the total. Some of it may be subject to revision if you find out the client had their current balance or whether there was a prepayment penalty wrong, but you should be able to get it within no more than a dollar, otherwise. It is one of the lending industry's big dirty secrets that the lender who underestimates the real figures by the largest amount will win the business. The one that tells a given consumer the best fairy tale gets their signature on a loan application. Despite the fact that these fairy tales are not binding in any significant way without a Loan Quote Guarantee, rare indeed is the consumer who will penalize the lender who lies to get them to sign the application, by not signing the final loan documents thirty or sixty days later.

I've already discussed the major ways in which people were qualified for loans they couldn't really afford, and the ways that were available to a competent loan officer to make it appear as if a given client could afford a given loan. And people who don't understand what was wrong with these are still looking for them. I got a search hit yesterday for "1% loan 120% of value." I get comparable search hits most hours of most days. People think these loans are good for them because they enabled them to buy a more expensive property than they could really afford (or "cash out" refinance for toys when they shouldn't have). But the real cost of the money was there and lurking all along, and none of this was explained to them. Furthermore, the vast majority of people whom I explained it to proceeded to go ahead and do it anyway, because it was so attractive to them now. They didn't do it with me, despite the fact that I told them if they were certain they wanted to do it, I could get it done. They went out to someone else who pretended the downside wasn't there. The downside was there, but by pretending it wasn't, these providers persuaded millions of people to do loans where they were cutting their own throat in slow motion. But people didn't want the truth - that they were heading towards an inevitable disaster - they wanted to pretend that everything was hunky-dory, and they richly rewarded those who pretended it was so.

How do we prevent this from recurring? Three answers: mandatory and full timely disclosure, a more transparent process, and more responsibility in fact. None of these are present currently. The lending and real estate industries and their lobbyists will fight all three of these, but they are all necessary if we really want to deal with the problem.

Let's detail what I'm talking about.

Instead of the joke that is the current Mortgage Loan Disclosure Statement, let's require prospective loan providers to tell the whole truth about a loan before the client commits by signing up. It's not difficult for a loan originator to figure out what the real costs are going to be, and what the rate really is going to be. We've already established that if they don't know all of the characteristics of a loan before they try to sell it, something is wrong. So the loan originator really should know everything about a loan as soon as the prospective consumer furnishes basic information. Let's make it mandatory to tell the consumer the truth of all of those neat little details when they sign up, rather than when they sign final paperwork. Let's start with a real accounting of the new balance: "This loan will cost you 1 point of origination and 1 point of discount. Administrative costs to finish the loan will be $3022, including all third party fees. You have indicated that you will/will not be adding the cost of one month interest to the loan in order to skip one payment. There will/will not be an impound account set up to pay property taxes and homeowner's insurance, requiring an initial amount of $n/a, which will be paid by check/adding it to loan balance. Starting from your initial balance of $200,000, this leads us to a final balance on your new loan of approximately $208,186. If this number is not correct within $100, your loan provider must present you with an updated estimate via this form at least ten calendar days prior to final loan documents." This puts an honest accounting of what the loan is really going to cost in the consumer's hands right away. It removes the incentive for low-balling, because the client is going to know about any changes ten days in advance - enough time for their competitors to get the loan done. Here's an article discussing how much it's legal to low-ball a loan quote, and the lenders keep pretending that quote is real, even though they know it isn't, right up until loan signing, where the consumers usually have no choice but to sign the documents for the loan they were lied to about all along.

Then let's have a section on characteristics of the loan: I don't like 2/28s, but let's use one for an example, just to show how well undesirable terms should stand out: "The initial interest rate will be 6%. This will be fixed for 24 months. After this initial period, your interest rate will be determined by 6 month LIBOR plus a margin of 2.8%, determined every 6 months. Should this index remain where it currently is, your interest rate will be 8.2% upon full adjustment. This loan is fully amortized/interest only for a period of n/a months/negatively amortized for up to n/a months, after which, it will fully amortize. If this loan features negative amortization, your balance will increase by $n/a if you make the minimum payments for this period. Should any of these numbers other than the value of the applicable index change, your loan provider must present you with an updated estimate via this form at least ten calendar days prior to final loan documents." This lets the consumer know exactly what they're getting into, before they have no choice but sign the documents or lose the deposit, while still have time to shop for something else.

Let's disclose the effects of any prepayment penalty, as well! "This loan does/does not include a prepayment penalty. Should you pay it off within 24 months of funding, you will be required to pay a penalty of 100% of six (6) months interest upon the loan. At current values, this is approximately $6245.58. If any of these values changes by 1% of the estimated value, your loan provider must present you with an updated estimate via this form at least ten calendar days prior to final loan documents." Let's put a dollar figure on that pre-payment penalty, so people know what they're risking. It's not like this is Monopoly money!

Now, let's disclose the payments, and the real costs of keeping the loan: "The initial monthly cost of interest on this loan will be $1040.93. Assuming the underlying index remains constant, the cost of interest will be $1422.60 per month at full adjustment. The minimum initial monthly payment will be $1248.19. Assuming the underlying index remains constant, the monthly payment will be $1543.14 at full adjustment. If any of these values changes by 1% of the estimated value, your loan provider must present you with an updated estimate via this form at least ten calendar days prior to final loan documents."

Next, a little bit of transparency: "This includes a rate lock of 30 days, and is subject to change until such time as the lender accepts the rate lock. Your loan is/is not currently locked. If it is locked, your lock expires n/a (date) and the loan must be funded by that time in order to receive this rate. Should any of these numbers other than the value of the applicable index change, your loan provider must present you with an updated estimate via this form at least ten calendar days prior to final loan documents.

Now, some real transparency! Let's tell the consumers what it will take to qualify: "This loan requires full documentation of income/stated income/no income requirement. It requires a debt to income ratio not exceeding 50%, and a loan to value ratio not exceeding 80%. This quote is based upon a FICO score of 640, with the following mortgage delinquencies in the preceding 24 months 2x30 0 x 60 0 x90, and the following non-mortgage delinquencies n/a x30 n/a x 60 n/a x90. Based upon known debts service of $1643 per month, of which $1483 will be replaced by this loan, and prorated monthly property taxes of $166 per month and prorated insurance costs of $72 per month and other monthly housing costs of $230 per month, you will need an monthly income of $3753 to qualify for this loan, and the property must appraise for a minimum of $260,250 in order for this loan to be accepted by the underwriters. If any of these values changes by 1% of the estimated value, your loan provider must present you with an updated estimate via this form at least ten calendar days prior to final loan documents. Note that misrepresentation of your financial position or of the property value is a felony punishable by up to five years in federal prison, and conspiracy is a separate felony offense also punishable for up to five years in federal prison, and you may also forfeits legal protections afforded most consumers" Most people can look at this and tell if they qualify. No more loan providers baiting someone with a loan they know they're not going to qualify for! There could even be a standard list of common "loan busters" attached. Finally, it lets people know that they need to tell the truth, the whole truth, and nothing but the truth in order to receive all of those nice protections the law has granted consumers against lenders. Furthermore, other people, such as agents and sellers, can look at this and see something that really tells them whether or not these people are going to qualify for this lean. No stringing other people along for two months before they find out the loan isn't possible!

My point is this: Both consumers and those who are honest loan providers will benefit from moving the moment of truth forward from final loan documents. The only people that will be hurt are those who make a habit of low-balling their estimates - telling people about loans that there's really no way they can deliver. The current situation, where consumers are likely to sign up with the person that tells them the best fairy tale, even if they shouldn't get a loan at all. The current situation encourages telling fairy tales in order to get people signed up. I don't think anyone will argue that's a good thing. The replacement should encourage people to understand how loans really work.

I've discussed disclosure and transparency. Now let's consider responsibility. The best laws do no good unless they're enforced, and enforcement has to start getting tough for real. Furthermore, for many years a lot of large companies have gotten away with saying they train their people to follow the law, when in fact they let it be known they'll wink at violations so long as you bring in a little more business because of it, if not actively encouraging violations when the regulators backs are turned. They'll make their people sign off on a piece of paper that says the company told them about violating the "do not call" list, or that soliciting other agent's listings is illegal, or any of dozens of other violations, while letting it be known that the company will wink at violations if not actively encourage them. And I'm just talking about things that are flatly illegal here, never mind things that may be unethical but not illegal, such as telling people they have a $400,000 loan for $1287, encouraging people who already have loans at 5% to exchange them for negative amortization loans at 8%, where the minimum payment may be less for a while, but the real cost of the money is $2700 per month, as opposed to the under $1700 of their current loan. Just forgetting to mention little things like that.

Nor can the hunt for responsibility stop at the first broker supervisor up the chain. Companies that make it clear they want you to follow the law don't have nearly as many difficulties. If more than a very small percentage of loan officers or agents working for a given chain do something they shouldn't have, it wasn't likely to have been spontaneous disregard of the rules. The big chains know that under the current set up, they'll lose the occasional low level victim to the regulators, but nobody important will ever be prosecuted. That needs to change. At one point in time, I was waiting to interview at a loan place which shall remain nameless, and heard someone described as a "national vice president" giving a class that was not only incorrect as to the facts of the matter, but intentionally misleading in such a was as to make it easier for the loan officers he was instructing to rationalize putting a client into a bad loan. But if the only penalty such companies face is a slightly higher turnover of underlings, while they're permitted to keep the increased level of business that results, that is not the way to encourage good, ethical, responsible behavior. Nor is it sufficient to train the people you're allegedly responsible for in legal CYA maneuvers and declare training complete.

Let's consider advertising for a minute. Currently, it over-promises the moon, just in order to get people to call. "$400,000 loan for $1287 per month!" to use the example of one web advertiser I've seen way too much of. The cost of that loan isn't $1287 per month. That's just the minimum payment. The real cost of that loan is $2700 per month, and increasing if the borrower makes that minimum payment. Net result: Millions of people who gave up good loans for lies, and have now lost their homes, or are in the process of losing their homes, because of it. Advertising needs to be required to focus on the real cost of the money. The interest rate, and how much in dollars it will cost to get that loan done. If they had to advertise a rate of 8.2%, they wouldn't get nearly so many gullible people signing up. If those people who make a habit of advertising a loan with a low rate instead of a low payment, then they're going to need to explain that that $400,000 loan at 5.5% will cost $24,000 to get it done. There's always a Tradeoff between rate and cost, except when they can sucker someone into applying for a loan that has a high rate and high costs.

Enforcement needs to be faster. There is no reason why every HUD 1 that gets filed cannot be checked for compliance by a computer program, and flag for human evaluation those that fall outside of set parameters. It needs to be compared to the earlier paperwork the client was given, and checked for compliance with the law, not wait until someone actually loses their property before the government starts to act. Swifter, more certain punishment will deter more of the unethical and illegal acts before they happen. Elementary psychology. Sadly, there are those that can only be deterred by confiscating their license permanently and sending them to Club Fed for several years, but the rest of us are better off without them in the business, but the sooner we confiscate that license, ban them from the industry, and put them away, the fewer people that will get hurt as the result of their actions.

Another thing: For as long as real estate agents and loan originators are the same license, it's time to stop pretending that one doesn't need to know the basic job functions of the other. Professionals who deal with real estate every day are much better equipped to recognize malfeasance, and stop if before it gets to the point where their client is getting hurt. If you don't warn your client of any issues you see, you have violated fiduciary duty, and nearly as deserving of punishment as those who commit it. No, you can't recognize everything that happens before it does. But there's no excuse not to have an affirmative requirement to investigate, not to turn someone in to state regulators, but to inform their client that all may not be as it seems. This may meet resistance from loan officers and agents who want the other to continue to share business, but who is really entitled to more protection: The person who leaves you open to charges that you failed your client, or that client, who really does directly and measurably put money in your pocket?

There can only be one answer to that question.

Caveat Emptor

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